Apart from the EBIT – EPS, EBIT – EPS analysis, the ability of a firm to use debt, from the profitability point of view, can also be judged in terms of a coverage ratio, namely.
The ratio measures the size of the interest payments relative to the EBIT. The reciprocal of this ratio (EBIT) measures the proportion of EBIT devoted to interest payments. The higher the coverage ratio, the greater is the certainty that the firm would be in a position to meet its obligations of interest payment.
The coverage ratio can be calculated, like the EPS, for. various levels of EBIT. This would provide a better picture of the firm’s most likely EBIT to meet out specific commitments. It will throw light on the adequacy of EBIT to meet the firm’s annual burden of payments connected with interest on loan, preference dividend, contribution to sinking (if any) and other repayments of principal.